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August 16, 2013

Are We Headed to Mandatory Retirement Savings Accounts?

A bill passed in California, and awaiting technical fixes, would provide self-funded pensions to workers without 401(k) plans

The U.S. retirement system of Social Security supplemented by private retirement savings is often thought to be in crisis, because of questions about the solvency of the former and the adequacy of the latter.

But the U.S. approach is not the only way — Australia and Chile, for example, have high mandatory contribution rates of 9% and 10%, respectively. And while these alternate approaches may seem remote and exotic, a piece of legislation gaining traction in the largest U.S. state may move the U.S. significantly in that direction.

The program would deduct 3% of their pay and then, cutting out the financial services industry, invest the funds of these millions of workers in a state-administered investment pool that would guarantee a modest 3% return. The accounts would be underwritten by insurance companies so as to avoid taxpayer risk and upon retirement, workers would receive a pension annuity.

The legislation, introduced last year, has already been through committees and been passed by both Houses of the Legislature and approved by Gov. Jerry Brown. But the plan must be vetted by the Internal Revenue Service and Department of Labor to be sure it does not conflict with federal law, then re-approved by the California Legislature after technical fixes have been made.

Writing in The Guardian’s Money Blog, Helaine Olen, author of a recent book blasting the financial services industry, heralds the arrival of a plan she regards as providing pensions to “people without the luxury of retirement planning, or the access to good financial advice.”

Citing a $6.6 trillion deficit in Americans’ retirement savings, and a private retirement system that earns Wall Street billions but leaves millions of Americans inadequately covered, Olen applauds the California approach’s mandatory savings feature and the lower costs and higher returns expected of a plan that can be scaled for the masses.

Commenting on Bloomberg View, columnist Megan McArdle expressed skepticism. Using an annuity calculator and inputting best-case work history assumptions, McArdle found that the average low-income worker would be adding a quite measly income supplement during retirement based on the limited contributions and tiny guaranteed return. “Guaranteeing a benefit is really, really expensive,” McArdle says.

“In fact, the majority of people would be better off if you took that 3% and stuck it in an S&P 500 index fund. Your real return, after taxes and fees and inflation, from 1982 to 2012 would have been about 5.8%,” she adds.

The California legislation is based on the ideas of New School for Social Research economist Teresa Ghilarducci. In an interview with Pensions & Investments earlier this month, Ghilarducci noted that mandatory retirement investing’s time has come.

“My audiences are governors and treasurers, mayors and city controllers," she said. "They know they will be stuck with the bill when their older residents are poor, near poor and needy. By letting all workers use the state or federal pension systems, we are allowing all workers to have access to the best money managers in the world.”